December 2009 - answers - ACCA

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Answers
Professional Level – Options Module, Paper P7 (MYS)
Advanced Audit and Assurance (Malaysia) December 2009 Answers
1 (a) (i) It is mandatory to perform analytical procedures as part of risk assessment. Analytical procedures can help the auditor
to develop an understanding of the entity, and highlight matters of which the auditor was previously unaware.
Procedures are therefore invaluable in terms of developing knowledge about the operations and performance of the
entity. For example, this may be particularly important in the case of a new audit client, when analytical procedures
such as a comparison of margins made by the entity with those made by its competitors will provide the auditor with
some degree of knowledge about the relative performance of the entity within its business environment.
In addition, performing analytical procedures at the planning stage may indicate aspects of the financial statements
which appear to carry a high risk of material misstatement. This would happen when unexpected trends and unusual
relationships between pieces of financial data were revealed by the analytical procedures. For example, procedures may
reveal that revenue has increased by 20% compared to the previous year, but that the budgeted increase was only 5%
and the industry average increase was only 8%. These results could indicate the possible overstatement of revenue, and
thus the auditor has been alerted to a possible material misstatement in the financial statements.
For these reasons, performing analytical procedures can help the auditor to identify and to prioritise potential areas of
risk, and to develop an appropriate audit strategy to minimise detection risk.
(ii) Analytical procedures are usually performed before the financial year end, and will therefore be based on draft projected
figures up to the year end, or interim financial information, budgets and management accounts. This may make the
analysis problematical for the following reasons.
Firstly, the information will not cover the entire accounting period. Extrapolating figures to cover a 12 month period is
not always easy to do, especially for a seasonal business where income and expenses do not accrue evenly throughout
the year. Care must be taken when performing the procedures to take account of this, and it should not be assumed
that income and expense figures should simply be grossed up on a monthly basis to enable annual comparisons.
Secondly, year end close down procedures will not have occurred. For example, many entities will only account for items
such as asset impairments or revisions to estimated figures such as provisions at the financial year end. Thus
comparisons to figures derived from prior year published accounts may not be valid.
Thirdly, information may be produced differently during the year, controls may be weaker, and the internal management
accounts may not be produced in compliance with the same reporting framework as the year end financial statements.
Measurement, recognition and presentation of financial information may be very different, so care should be taken when
extracting figures from management accounts to be used in comparisons with published financial information.
Finally, some entities, especially smaller companies, may not have a complete or formal reporting system during the
year, making analytical procedures before the year end accounts have been produced difficult. It may be possible to
perform some limited analysis on the information that is available before the year end, but the use of this analysis will
be limited due to its incomplete nature. This means that it may be impossible to base expectations on the data, as it is
incomplete at the time of the preliminary analytical review.
(b) The definitions of ‘overall audit strategy’ and ‘audit plan’ are found in AI 300 (Redrafted) Planning an Audit of Financial
Statements.
The overall audit strategy sets the scope, timing and direction of the audit. Scope involves determining the characteristics of
the audit client, such as its locations, and the relevant financial reporting framework, as these factors will help to establish
the scale of the assignment. Timing refers to establishing deadlines for completion of work and key dates for expected
communications. Establishing the overall audit strategy also includes the consideration of preliminary materiality, and initial
identification of high risk areas within the financial statements. All of these matters contribute to the assessment of the nature,
timing and extent of resources necessary to perform the engagement.
The overall audit strategy should then lead to the development of the audit plan.
The audit plan is more detailed than the audit strategy and includes a description of the risk assessment procedures, and the
further planned audit procedures necessary at the assertion level for gathering evidence on the material transactions and
balances in the financial statements. The general purpose of developing the audit plan is to design audit procedures which
will reduce audit risk to an acceptably low level.
The difference between the audit strategy and the audit plan is therefore that the strategy is the initial planning to ensure there
will be adequate resources allocated to the audit assignment in response to an initial evaluation of the entity’s characteristics,
whereas the audit plan is a detailed programme of audit procedures.
The strategy will therefore usually be developed before the plan, however, the two activities should be seen as inter-related,
as changes in one may result in changes to the other. Both the strategy and the plan should be fully documented as this
represents the record of proper planning of the audit assignment.
(c) Financial information is needed in order to calculate operating and net margins and to compare to prior period(s). If possible,
separate information from the income statement, and asset and liability information should be obtained for each segment of
the business.
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It is important that the information is disaggregated as Papaya Co operates in different business segments and different
geographical locations. Information would be needed at a minimum level of disaggregation as follows:
– Financial information for the Papaya Mart chain of supermarkets
– Financial information for the operations in Farland
– Financial information for the Papaya Express chain of supermarkets
– Financial information for the new financial services division.
The information should be separated out as above to enable analytical procedures to be performed on each separate
component of the business, as each component is likely to achieve different margins and returns on capital. Calculating ratios
and making comparisons for the company as a whole would be relatively meaningless. For example, the margins made by
the two different supermarket chains are likely to be different, as the Papaya Express stores are in city centres where overheads
are likely to be much higher than in the out of town locations used by the Papaya Mart stores. The two types of supermarket
also sell a different range of goods, which will also make the overall margins different.
Analytical procedures should be performed on the operations in Farland as a separate exercise if possible. This division is
likely to have a different cost base, and revenue may be based on a different pricing structure due to the overseas locations
of the stores. There may also be distortions to the figures caused by retranslation into the currency of Papaya Co.
The financial services division will have a completely different profit structure, cost base and return on investment than the
retail divisions and so must be analysed separately. It is likely to be much less capital intensive, which will mean that returns
on investment and asset utilisation ratios will be very different to the retail divisions.
Information about any significant non-recurring items of income and expense for each division should also be requested as
these would cause fluctuations in profit and make comparisons difficult if not taken into account. For example, the heavy
advertising costs of the new overseas operations will reduce the margin of that division of supermarkets compared to the local
stores.
Budgeted information should also be requested. This will be important for the two new divisions – the foreign stores, and the
financial services division. As these are start-up activities during the year, there will be no possible comparisons to prior year
information. Therefore the main analytical procedures to be performed will be comparisons of actual to budgeted performance.
The auditor should bear in mind the reliability of the budgeted information when performing these procedures.
The auditor should also request any information about new accounting policies or estimation techniques which have been
used this year. New accounting treatments may distort comparisons, so full understanding of the impact of any new policies
is important when evaluating the results of analytical procedures. For example, the new forward exchange contracts entered
into during the year will have caused the introduction of a new accounting policy which may cause fluctuations in profit.
It is also useful to make comparisons to similar companies in the same industry. There should be financial information which
is readily available for Papaya Co’s competitors in the supermarket retail sector, and also for financial services companies.
This is a useful source of information, as the auditor will be able to gauge the relative performance of Papaya Co, and assess
if margins and returns are similar to industry comparisons or averages. Care should be taken however, when comparing the
new divisions to industry competitors, as there may be one off start-up costs included in the income statement for this year,
which will reduce profitability.
(d) Briefing notes to be used at audit planning meeting
Subject: Financial statement risks identified at planning meeting
Introduction
At a recent planning meeting held with the finance director of Papaya Co, several issues were discussed which could lead to
financial statement risks. All of these issues relate to matters which are potentially material to the financial statements.
Alleged collusion and price fixing
It appears that several companies are under investigation for breaching regulations, and Papaya Co could face potentially
material financial penalties if found guilty. The situation needs to be assessed by reference to FRS 137 Provisions, Contingent
Liabilities and Contingent Assets. The risk is that the financial statements do not reflect the situation as either a provision or
a contingent liability, depending on the evaluation of the potential outcome of the case. If it is considered that the company
faces a probable cash outflow, then a provision and associated expense should be recognised. If the outflow is considered
possible, then a note to the financial statements should describe the contingent liability and show an estimate of the potential
financial effect. Therefore the financial statement risk is both understated liabilities and overstated profit, if the cash outflow
is considered probable but no provision is made. Alternatively, the risk is incomplete disclosure if the outflow is considered
possible and no note is provided.
Convertible debentures
According to FRS 132 Financial Instruments: Disclosure and Presentation, convertible debt instruments should be presented
in the balance sheet split into two separate components. This is because the company does not know if it has an obligation
to pay cash on the redemption of the debt in 2015, or whether the debt will be settled by an equity distribution. Therefore,
on the receipt of cash proceeds, the credit entry is split between debt and equity. The debt is valued by discounting the
potential cash outflows to present value, with the credit entry to equity a residual balancing figure. The financial statement
risk is firstly that split accounting has not been applied, so the whole of the credit has been recognised as either debt or equity,
and therefore incorrectly recognised in the balance sheet. This would then have a further consequence for the income
statement, as any finance charge calculated on the basis of an incorrect debt component would then also be incorrectly
measured.
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Forward exchange contracts
These contracts are derivative financial instruments. As such, they must be recognised in the balance sheet at the year end,
as a financial asset or a financial liability, depending on whether the terms of the derivative contract are favourable or
unfavourable at the reporting date. The financial statement risk is that the derivatives have not been recognised at all,
particularly because the contracts were acquired at no cost, so there is no accounting entry when the contract is taken out.
A second risk relates to the valuation of the derivative asset or liability. This could be complex to calculate, and if not
performed by an experienced specialist, could cause the over or understatement of the financial instrument recognised, and
an associated incorrect entry recognised in profit. Finally, FRS 132 Financial Instruments: Disclosure and Presentation also
imposes disclosure requirements in relation to derivative instruments. The risk is that disclosures made in the notes to the
financial statements are incomplete.
Land held for development potential
There are indicators that the land could be impaired at the year end. Some land was sold at a loss during the year, and it
seems that planning permission for the development of the sites is becoming harder to obtain, meaning that the value of the
land has fallen. Following FRS 136 Impairment of Assets, an impairment review must be carried out if there are indicators
of impairment to an asset. It is likely that land will be overstated in the balance sheet, and expenses understated, unless an
impairment review is conducted and any resulting loss fully recognised.
Inspection of warehouses
A new regulatory requirement has resulted in an inspection of all of the warehouses operated by Papaya Co. Under FRS 116
Property, Plant and Equipment, costs of a major inspection should be capitalised and then depreciated over the period to the
next inspection. The risk is that the cost has been expensed, in other words, treated as an operating expense. This would
result in understated profit and understated non-current assets.
Other financial statement risks (not arising from notes made at the planning meeting) include the following:
Disclosure of operating segments
FRS 114 Segment Reportingrequires listed companies to disclose in a note to the financial statements information about the
performance of each reportable segment of the business. Papaya Co has two potential new disclosures this year end. The
first is the new financial services division, which is likely to be a separate reportable segment under FRS 114. The second
new disclosure relates to the overseas expansion of the company, as FRS 114 requires disclosure of geographical analysis of
assets, liabilities, revenue and expenses. The financial statement risk is the non-disclosure of information relating to these
new business and geographical segments.
Internally generated brand names
Papaya Mart and Papaya Express are internally generated brand names. FRS 138 Intangible Assetsprohibits the recognition
of internally generated brands. The risk arises from significant expenditure on the launch of the brand in Farland. If any of
the associated expense has been capitalised as a brand name, this would mean that non-current assets are overstated, and
profit for the year would be overstated.
Conclusion
There are several financial statement risks identified at the planning meeting, resulting from the company operating in a
regulated industry, changed market conditions, and new business activities for the company. Now that the risks have been
identified, an appropriate audit strategy will be devised to minimise the risk of material misstatement in relation to these
matters.
Tutorial note: Credit will be awarded for other financial statement risks identified from the question scenario, such as
potential over-valuation of inventories, classification of land as held for sale, incorrect timing of recognition of revenue from
financial services products, and potential impairment of loans made to financial services customers.
2 (a) (i) Training costs
Matters to consider
Materiality– the relevant materiality calculations are:
Based on revenue: 500,000/12·5 million x 100 = 4%
Based on net profit: 500,000/400,000 x 100 = 125%
Based on total assets: 500,000/78 million x 100 = <1%
Based on the above, the training costs are immaterial to the balance sheet, but material to the income statement and
therefore to revenue and profit. It is important to note that any adjustment made to recognise the costs as an expense
will have the effect of turning the profit of RM400,000 currently recognised into a loss of RM100,000.
Accounting treatment
The finance director’s argument is based on the idea that the training costs are directly related to the assets concerned
and therefore should be capitalised. FRS 116 Property, Plant and Equipment (paragraph 19 c) does not permit the
capitalisation of these costs as they are operating costs rather than costs directly attributable to the item of plant. The
concept behind this is that assets should only be recognised if they are controlled by the entity. It is unlikely that
Banana Co can exercise control over the skills of its staff which have been developed by the training programme, as staff
may decide to leave employment with the company. In addition, FRS 138 Intangible Assets also argues against the
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recognition of training costs as an intangible asset. Therefore there are no grounds for recognising the training costs as
a non-current asset, and the RM500,000 cost of the training programme should be expensed in the financial
statements.
Audit opinion
If the financial statements are not amended, the audit opinion should be modified due to a disagreement in accounting
treatment. This would most likely be a qualified ‘except for’ opinion due to the material nature of the disagreement.
Evidence
– A schedule detailing the major categories of expenses which make up the total RM500,000 costs of the training
programme.
– Agreement of a sample of the costs per the schedule to supporting documentation such as invoices provided from
the external training firm.
– Agreement of a sample of the costs to the cash book and/or the bank statement.
– Confirmation that the training programme was completed before the year end (i.e. that none of the RM500,000
represents a prepayment of costs).
– Confirmation that the RM500,000 is complete, and that no further invoices received after the year end in respect
of training carried out before the year end should have been accrued.
– Clarification that Banana Co does not exercise specific control over the skills of its staff, by a review of standard
terms of employment.
– Confirmation that the amount spent on the training programme agrees to an authorised budget or an approved
expenditure programme relating to the new machinery, and that the amount incurred is in line with expectations.
(ii) Trade receivable
Matters to consider
Materiality– the relevant calculations for the total value of the trade receivable are as follows:
Based on revenue: 300,000/12·5 million x 100 = 2·4%
Based on net profit: 300,000/400,000 x 100 = 75%
Based on total assets: 300,000/78 million x 100 = <1%
Therefore the total receivable is not material to the balance sheet, however, it is material to the income statement and
therefore to profit for the year, which is relevant given that it appears that an impairment loss should be recognised in
respect of this amount.
Accounting treatment
FRS 139 Financial Instruments: Recognition and Measurementrequires that impaired trade receivables are recognised
at fair value, which is the present value of estimated cash inflows. According to the information provided by Cherry Co’s
administrators, it is likely that 25% of the amount outstanding will be paid. Therefore, it seems that 75% of the
RM300,000 is irrecoverable, and so an impairment loss of RM225,000 should be recognised. This is material to the
income statement, illustrated by the following materiality calculations:
Based on revenue: 225,000/12·5 million x 100 = 1·8%
Based on net profit: 225,000/400,000 x 100 = 56%
The potential expense to be recognised is highly material to net profit.
A further issue is that there may be inventory in relation to Cherry Co within current assets. As Banana Co has several
contracts with Cherry Co, there may be raw materials purchased specifically for use in a contract agreed with Cherry Co,
or items of work-in-progress. As Cherry Co is in insolvency, all activity on such contracts will cease with immediate effect.
Any such inventory should be reviewed to see if it can be re-allocated to different contracts or back into general inventory.
If not, the inventory should be written down to the lower of cost and fair value less costs to sell, with the associated loss
recognised in profit for the year.
Audit opinion
If the impairment loss on the trade receivable is not recognised, the audit opinion should be modified due to a
disagreement in accounting treatment. This would most likely be a qualified ‘except for’ opinion due to the material
nature of the disagreement.
Looking at the two issues together, it appears that with the adjustments needed in respect of the training costs, and the
impairment to be recognised for the receivable, the income statement should show a loss for the year of RM325,000
(400 – 500 – 225). If the adjustments are not made, the auditor may come to the opinion that the balance sheet is
rendered meaningless, and may issue an adverse opinion, stating that the financial statements are not fairly presented.
Tutorial note: Credit will be awarded for discussion of going concern issues arising from the loss of a major customer.
Audit evidence
– The initial correspondence from the administrators of Cherry Co confirming that the company is insolvent and that
only 25% of amounts outstanding is likely to be paid.
– A written confirmation from the administrators of Cherry Co stating the amount that is likely to be paid, and an
anticipated payment date.
– Agreement of the amount owed by Cherry Co to the receivables ledger, and to confirmation from the administrators.
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– Recalculations of the impairment losses.
– A review of inventory documentation for the value of inventory relating to contracts with Cherry Co.
(b) Evaluation of the management of the audit of Banana Co
The comments made by the junior indicate that the audit has not been properly planned or supervised. Both ISQC1 Quality
Control for Firms that Perform Audits and Reviews of Historical Financial Information and Other Assurance and Related
Services Engagements, and AI 220 Quality Control for Audits of Historical Financial Information (Revision)provide guidance
in this area. There are many indicators of poor quality control which are evaluated below.
No audit planning meeting was held at the start of the audit.A meeting is important as this is where the audit partner should
direct the audit assignment by explaining to the members of the audit team their responsibilities, the nature of the client’s
business, and significant risk or fraud indicators identified, and the detailed approach to the audit. If no meeting is held at
the start of the audit, then it is unlikely that members of the audit team will understand the audit strategy, the objectives of
the work they have been asked to perform or how tasks have been allocated amongst members of the team. The audit partner
should lead the meeting, as it is their responsibility to ensure that the audit is directed, supervised and performed in
accordance with professional and regulatory standards.
Audit manager and supervisor are not always available.All audit assignments should be properly supervised. In the absence
of a manager and supervisor, the more junior members of the audit team will not be able to resolve problems which arise,
and the longer there is a lack of supervision, the more problems will accumulate. Without supervision, the audit plan may
not be properly followed, and inappropriate modifications may be made to audit programmes.
Junior was given the tasks of auditing goodwill and inventory. It seems that audit work has not been properly delegated
amongst members of the audit team. An inexperienced audit junior should not be given relatively complex procedures to
perform. Both goodwill and work-in-progress can be challenging to audit, and involve the use of judgement (e.g. the
evaluation of the stage of completion of work-in-progress), and it is unlikely that a junior who has only been on two audits
will have enough knowledge and experience to fully understand the complexities of the accounting and audit issues involved.
Tasks associated with goodwill and work-in-progress should be allocated to a more experienced member of the team, leaving
more straightforward tasks for the junior.
Junior helped with the count procedures during the inventory count. The junior did not understand the objectives of the
inventory count. Test counts should have been performed by the junior, in order to gather audit evidence for the completeness
and existence of inventory items, but members of the audit team should not ‘help out’ the client’s staff with counting. Instead,
the junior should have observed the client’s staff and assessed whether the count was being performed in accordance with
count instructions.
Junior asked to challenge the finance director. It is inappropriate for an inexperienced junior to challenge a senior member
of client’s management. Contentious issues should be discussed with the client by the audit manager or partner, as they have
a more appropriate level of authority and will be in a better position to explain why the provision is considered to be
inadequate. This is an inappropriate delegation of tasks within the audit team.
Inadequate time to complete necessary audit procedures.It seems that either not enough time has been allowed to complete
the necessary audit procedures, or that in the absence of much direction and supervision, the audit procedures have been
performed inefficiently. One of the key aspects of supervision is to keep track on the progress of the audit engagement. The
audit plan should initially determine appropriate timescales and deadlines, and if it transpires that more time is needed, this
should be discussed with the client.
Modification to planned audit procedures. The audit procedures have been changed in response to lack of time. It is not
acceptable to cut corners by reducing sample sizes or changing the items selected for the sample. Modifications should be
discussed by senior members of the audit team, and should only occur for genuine reasons. The danger is that reduced
sample sizes or changing the items selected for testing will not provide sufficient, reliable audit evidence as the sample
selected may no longer be representative of the population as a whole.
Conclusion
Poor quality control means that this audit engagement has not had appropriate direction and supervision. The evidence
gathered may be inappropriate and inadequate for the purposes of issuing an audit opinion. This could result in an incorrect
opinion being issued. A detailed hot and cold review should be performed to determine if any areas need extra audit work
performed, and to consider what measures the firm should take to improve its quality control monitoring procedures.
(c) Briefing notes to be used at training session
Subject: Money laundering policies and procedures
(i) Introduction
In recent years accountants and auditors have become subject to anti-money laundering regulations. This is largely due
to the work of the inter-governmental body the Financial Task Force on Money-Laundering (FATF). A firm of Chartered
Accountants must establish sound policies and procedures to ensure that the firm meets its responsibilities under the
relevant regulation in which the firm is operating. It is important that everyone who is a member of an audit engagement
team is aware of the regulations, the firm’s policies and procedures, and their own responsibilities regarding money
laundering activities.
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Definition of money laundering
Money laundering is a process by which criminals attempt to conceal the true origin and ownership of the proceeds of
criminal activities. It is a way in which money earned from criminal activities (‘dirty money’) is transferred and
transformed so it appears to have come from a legitimate source (‘clean money’). Money laundering includes a wide
range of potential crimes including possessing, dealing with, or concealing the proceeds of crime.
Illustrations
Money laundering activities could include:
– Acquiring, using or possessing the proceeds of criminal activities such as drug trafficking and terrorist activities, or
retaining control over the proceeds of tax evasion.
– Benefits obtained through bribery or corruption.
– Inciting, aiding, counselling or concealing such activities.
The three stages of the money laundering process are placement, layering and integration:
– Placement is putting money into financial products or instruments, including life policies, pension arrangements,
unit trusts, travellers cheques, and bank deposits.
– Layering is creating a series of transactions so that the original source of funds is obscured and difficult to trace.
– Integration is converting the proceeds of money laundering into a legitimate form.
For accountants there are specific ways that they could commit offences relating to money laundering. These could
include:
– Handling the proceeds of criminal activity, or advising on the use of such proceeds.
– Failure to report knowledge or suspicion of money laundering activities to the appropriate authority.
– Making a disclosure which is likely to prejudice an investigation into money laundering (known as ‘tipping off’).
– Failure to comply with the specific regulatory requirements in relation to money laundering in the jurisdiction in
which the accountant is operating.
(ii) Policies and procedures
Appointment of a Money Laundering Reporting Officer (MLRO). The MLRO is a nominated officer who is responsible
for receiving and evaluating reports of suspected money laundering from colleagues within the firm, and making a
decision as to whether further enquiry is required and if necessary making reports to the appropriate external body. The
MLRO should have an appropriate level of seniority and experience and would usually be a senior partner.
Customer identification procedures.This is often referred to as customer due diligence, or ‘know your client’ procedures.
The point of these procedures is to ensure that the firm has verified the identity of clients (whether the client is an
individual or an entity), and has obtained evidence of that identity. For an individual, typical evidence of identity would
be a passport, driving licence, and evidence of address such as a utility bill. For an entity evidence may include a
certificate of incorporation. The identification process for an entity would also involve identification of key management
personnel and those people in control of the entity, and an assessment as to whether any connected individuals are
politically exposed people.
Enhanced record keeping. Records must be kept of clients’ identity, the firm’s business relationship with them, and
details of transactions with the client. All records should be kept for five years after the end of the business relationship
or completion of the transactions. Internal and external reports made in connection to money laundering should also be
securely kept for five years.
Communication and training. All relevant employees should receive training so that they are aware of the main
provisions of money laundering regulations, and so that they know how to recognise and deal with activities which may
be money laundering. The training programme should be offered to all members of the firm with an involvement in audit
engagements. Training should also be provided on the firm’s internal policies and procedures with relation to money
laundering. In particular all staff should be aware of appropriate lines of communication, and who they should report
suspicions of money laundering activities to. Training should be considered for all staff, including support staff who do
not carry out an advisory role.
Internal controls, risk assessment, management and monitoring. The firm should establish systems and controls to
effectively manage the risk that the firm is exposed to in terms of money laundering activities. This could include:
– Client screening procedures to minimise the risk of taking on a new client with a high risk of money laundering
activities
– Systems and controls to ensure that training is taken/attended and understood by all relevant employees
– Systems that allow periodic testing that the firms’ policies and procedures comply with legislative and regulatory
requirements.
All of the above contribute to the acceptance and following of firm-wide practices by all relevant individuals and can be
seen as quality control measures.
Conclusion
It can be seen that the firm needs to have in place appropriate measures to ensure that complex anti-money laundering
regulation is adhered to. It is the responsibility of all relevant staff to be alert for suspicious activities and to understand
their own responsibility to report the activity. Failing to do so places the individual and the firm at risk of a breach of
regulation.
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3 (a) Recommended procedures to be performed on the cash flow forecast include:
Accuracy checks:
– Agree the opening cash position to cash book and bank statement/bank reconciliation.
– Cast the forecast.
Cash receipts:
– Assess whether the assumption regarding the split of revenue between cash and credit sales is accurate by considering
whether it is in line with knowledge of the business.
– Agree the forecast cash receipts from cash sales to the forecast revenue figures in the profit forecast for January, February
and March 2010.
– Verify the 10% discount has been accounted for in calculating the cash sales by recalculation.
– Agree the 10% discount to a small sample of invoices raised.
– Recalculate the pattern of receipts from credit customers by applying the stated average credit terms to actual sales in
October, November and December 2009, and the forecast sales for January, February and March 2010.
– Review the latest aged receivables analysis available for confirmation of the pattern of payment from credit customers.
Purchases:
– Recalculate the pattern of cash flows relating to purchases by applying the stated credit terms to the forecast purchases
figures in the profit forecast.
– Using the latest available information, calculate a suppliers payment ratio to compare with the stated usual credit terms
applied to purchases of 30 days.
– Agree the 12% discount to invoices received, supplier statement reconciliations, or signed contracts with suppliers.
Other operating cash outflows:
– Discuss with the management of Apricot Co the relationship between sales and operating cash outflows. It appears that
outflows could be understated, as salaries and expenses are static, whereas cash receipts from sales are increasing over
the period.
– Agree the monthly salary cash outflow to latest available payroll records, and to the profit forecast.
– Obtain a breakdown of the contents of the overheads cash outflow category.
– Review the schedule for any non-cash items which should not be included, e.g. depreciation and amortisation, bad debt
expenses.
– Compare the components of the overhead cash outflow to a breakdown of operating expenses included in the profit
forecast, looking for omissions.
– For each of the main components of the overheads cash outflow, review supporting documentation such as invoices,
utility bills, and agree the amount paid each month.
Non-recurring cash flows:
– Agree the cost of the licence to supporting documentation, e.g. any correspondence already received from the issuing
body, and compare the cost of RM35,000 to the cost of the previous year’s licence.
– Confirm that the 2009 licence expires in December and that the new licence will be required in January 2010 by
reviewing the terms of the licence.
– Discuss the inspections required for the new licence to be granted, and ascertain if the inspections have yet taken place,
and if so, the results of the inspection.
– Review the board minutes, and minutes of shareholder meetings for approval of the dividend payment in February 2010.
Cash flows associated with the new premises:
– For the new fixtures, agree the estimated cost to supplier price lists, or to any quotations received.
– Discuss the timing of the cash outflow in relation to fixtures with management. Presumably the fixtures can only be put
into place once the premises have been acquired, which is planned for the end of March. It seems likely that the fixtures
will not be purchased until April, in which case the cash payment is recognised too early in the forecast.
– For the premises, agree the potential purchase price to correspondence with the vendor and solicitors.
– Obtain a breakdown of the potential cost of RM500,000 and review to ensure the cost is complete, i.e. have legal fees,
stamp duty and other associated costs been included.
– Review board minutes for approval of the purchase, and approval that the finance will be raised from Pik Choi.
General enquiries:
Enquire with the preparer of the forecast regarding the following:
– Enquire as to the competence and experience of the preparer of the forecast.
– No finance costs or tax payments appear to have been included – have they been omitted or are there no finance or tax
payments in the three-month period?
– Are there any other costs to be incurred in relation to the new premises in the three-month period? e.g. recruitment costs
for new staff, any additional working capital requirements, installation of plant and fixtures to the new premises.
– Discuss the reason for the acquisition of the new premises.
– Enquire whether any payments in advance or deposits will need to be made. Currently the full amount is forecasted to
be paid on the date of acquisition.
– Enquire about any other potential sources of finance in case Pik Choi fails to provide the full amount required, or in case
the new premises cost more than the estimated amount.
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(b) Main contents of an assurance report:
International Standard on Assurance Engagements AI 3400 The Examination of Prospective Financial Information provides
guidance on the content of an assurance report given when a professional accountant has examined forecasts or projections.
– Title and addressee.
– Identification of the prospective financial information (PFI); this should be by reference to a page number, or to the titles
of the statements which have been evaluated. There should also be a reference to the period that the PFI covers.
– A reference to AI 3400 adds credibility to the report because it has been prepared according to a recognised regulatory
statement.
– A statement that management is responsible for the PFI including the assumptions on which it is based. There should
be a page reference for the assumptions, as these are a key component of the PFI.
– Where applicable, a reference to the purpose and/or restricted distribution of the prospective financial information. The
report should caution readers that because the PFI is based on hypothetical assumptions, the events and figures
contained in the PFI may not necessarily occur as expected. There should also be a caution as to the potential use of
the PFI.
– A statement of negative assurance as to whether the assumptions provide a reasonable basis for the PFI. This would be
stated as follows: ‘nothing has come to our attention which causes us to believe that the assumptions do not provide a
reasonable basis for the projection…’.
– An opinion as to whether the PFI is properly prepared on the basis of the assumptions and is presented in accordance
with the relevant financial reporting framework.
– Appropriate caveats concerning the achievability of the results indicated by the PFI.
– The date, name of the audit firm, and a signature.
The following points are not specifically referred to in AI 3400, but would commonly be included by firms providing assurance
reports on PFI:
– A reference to the engagement letter and to the specific procedures that were requested, and have been carried out.
– A statement that the procedures carried out were those specified by the company and the third party to whom the report
is issued.
– Details of any errors and exceptions found.
If the auditor believes that the presentation and disclosure of the PFI is not adequate, the auditor should express a qualified
or adverse opinion. If one or more significant assumptions do not provide a reasonable basis for the PFI, the auditor should
express an adverse opinion on the report. A limitation in scope should be expressed if conditions preclude application of one
or more procedures considered necessary in the circumstances.
4 (a) (i) Definitions and contrast:
Prescriptive auditing occurs in a regulatory framework which contains fixed rules which must be followed, with little or
no consideration of whether or how the rules apply to a particular situation. In contrast, principle-based auditing occurs
in a regulatory framework which contains limited or no fixed rules, but instead is based on guiding principles which the
auditor must consider how or whether to apply in a given situation.
(ii) Advantages of a prescriptive approach:
Using prescriptive wording and rules should improve the clarity and understandability of auditing standards. The
problem is that principles-based standards use words like ‘should’ (e.g. the auditor should
understand/investigate/perform…) to indicate a requirement, which is not always clear. Does this mean a mandatory
requirement, or something which is best practice, but can be omitted if necessary? Prescriptive auditing standards (e.g.
using the word ‘shall’ instead of ‘should’) would make it clear exactly what is expected of the auditor, and therefore
reduce the scope for the auditor to misunderstand the exact requirements of the standard.
It can be argued that having more precise requirements in auditing standards will then lead to uniformity in audit
practice, and an improvement in audit quality, as the auditor will be in no doubt as to which procedures need to be
performed. It could also be easier to monitor the quality of work, as it would be easier to spot missing procedures.
Disadvantages of a prescriptive approach:
The main issue is that using a prescriptive approach, there is little or no scope for tailoring audit procedures to the
specific situation of a client. This means that over-auditing is likely, as the auditor is forced to carry out mandatory
procedures when there is really no need. This is particularly likely to be a problem in the audit of small entities which
have relatively simple transactions. These entities usually pose low risk to the auditor, but under a prescriptive auditing
regime, a wide variety of procedures would still need to be carried out. Equally, there is a risk of under-auditing, as under
a prescriptive approach there is little scope to consider whether further procedures, not mandatory under the auditing
standard, need to be performed.
Additionally, the lack of judgement which is needed under a prescriptive approach is a disadvantage of the approach.
Many entities are complex and present challenges to the auditor, which only experienced auditors will be able to deal
with. The problem is that under a prescriptive approach to auditing, audit staff will not gain experience of making
judgements.
This could lead to a reduction in the quality of audits conducted. It could also deter people from entering, or staying in
the audit profession, as audit work would become mundane and routine, and would not offer the chance to develop the
same skills as would be developed in a principles-based auditing environment.
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(b) (i) Auditors are required to identify and assess the circumstances which could adversely affect the auditor’s objectivity,
including any perceived loss of independence. Intimidation is one of the categories of threats to objectivity and
independence identified in IFAC’s Code of Ethics for Professional Accountants.
Intimidation means a threat arising when the auditor’s conduct is influenced by fear or threats. This could happen when
the auditor encounters an aggressive and domineering individual who could coerce or manipulate the actions of the
auditor using threatening behaviour.
However, intimidation is more likely to arise in the following ways:
– Being threatened with dismissal or replacement,
– Being threatened with litigation,
– Being pressured to reduce inappropriately the extent of work performed, e.g. in order to reduce audit fees.
Intimidation is often linked to other types of threats to objectivity and independence. For example, an auditor may be
more susceptible to intimidation if the other person is a close family member, as they may be able to exert significant
influence over the actions of the auditor. This is therefore linked to the familiarity threat.
When threats are identified (unless the threats are assessed as insignificant), the auditor should establish safeguards to
eliminate or to reduce the threats to an acceptable level. In some jurisdictions, the regulatory framework provides a
specific safeguard in the case of being intimidated with dismissal, as usually it is only the shareholders and not the
management of an entity that can remove the auditor from office.
(ii) Advertising
Advertising is allowed as long as the advertising does not go against any of the fundamental principles contained in
ACCA’s Code of Ethics and Conductor IFAC’s Code of Ethics for Professional Accountants.
Advertisements should be truthful and not make false claims. For example, it would be inappropriate to claim that
Peaches & Co could promise to offer a cheaper audit service than the competitor firm. Equally, it would be inappropriate
to make exaggerated claims regarding the experience or the qualifications possessed by the firm’s partners and
employees.
In addition, any advertisement should not make disparaging remarks about any other audit or accountancy firm, for
example, it would be inappropriate to state that Peaches & Co offered a higher quality service than any other provider.
Any advertisements should also be in compliance with any local rules and regulations. For example, in some jurisdictions
it is prohibited for professionals such as auditors to advertise on television, and most jurisdictions will have some kind
of regulatory authority, such as the Advertising Standards Authority in Malaysia, which imposes rules on advertising to
ensure it is not misleading and is in good taste.
(iii) Lowballing
Lowballing is a term used to describe a situation where an audit firm submits a tender to provide an audit service at a
very low fee, with the objective of under-cutting competitors’ prices in order to win the tender. The audit firm will hope
to recover the low fees quoted in the tender either by increasing the audit fee in the future, or by providing some lucrative
non-audit services.
The problem is that when low fees are charged for the audit, the quality of the audit work performed may suffer, as the
temptation will be to cut back on audit work in order to reduce costs. It could be perceived that the auditor is not acting
with due care and competence if not enough time is spent on audit work due to the low fee attached to the audit work.
This perception is damaging to the firm concerned, and to the profession as a whole.
IFAC’s Code does not prohibit this practice, but it does state that when a firm obtains an audit appointment at a
significantly lower fee than that quoted by competitors or the predecessor audit firm, the firm should be able to
demonstrate that appropriate time and qualified staff are assigned to the audit, and that all applicable standards are
being adhered to.
5 (a) Auditor’s responsibilities in relation to subsequent events.
Subsequent events are defined as those events occurring between the date of the financial statements and the date of the
auditor’s report, and also facts discovered after the date of the auditor’s report.
AI 560 Subsequent Events differentiates the auditor’s responsibilities in relation to subsequent events depending on when
the subsequent event occurs.
Events occurring up to the date of the auditor’s report.The auditor has an active duty to perform audit procedures designed
to identify, and to obtain sufficient appropriate evidence of all events up to the date of the auditor’s report that may require
adjustment of, or disclosure in, the financial statements. These procedures should be performed as close as possible to the
date of the auditor’s report, and in addition, representations would be sought on the date that the report was signed.
Procedures would include reviewing management procedures for ensuring that subsequent events are identified, reading
minutes of meetings of shareholders and management, reviewing the latest interim financial statements, and making
appropriate enquiries of management.
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